The big case for small-cap stocks

While large-cap stocks were outperforming, investors yanked assets out of small-cap mutual funds in 37 of the 40 weeks since May.

Stocks logged lousy returns last year as investors gave up on risk and favored the relative safety of bonds. Benchmark 10-year Treasurys rose more than 16 percent, while the S&P 500 did nothing on a price basis. But now that the so-called "risk-on" trade appears to be back in force, some investment strategists are making a big case for small-cap stocks.

Richard Bernstein, the well-regarded CEO of Richard Bernstein Advisors (and former chief investment strategist at Merrill Lynch), says U.S. in the entire global equity market this year. And now a new report from UBS (UBS) makes a similarly bullish case on the potential for small-cap stocks, too.

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Yes, small-cap stocks' tiny market values, lack of liquidity and relatively delicate balance sheets tend to make the asset class much more volatile. But that increased risk can also lead to outsized rewards, notes UBS Global Asset Management, in a new report to clients.

"Although small companies had weak performance in 2011, we believe it is a good time for investors to re-assess exposure to an area of equity markets that delivers superior long-term return potential," UBS says. "Valuation levels look reasonable against history and it would appear to us that the timing for investment could be fortuitous."

UBS bases its case for small caps on four main points:

-- While small companies are more cyclical and underperformed in the U.S. and Europe in 2011, over the long term, small-cap stocks have performed better than large-cap stocks

-- There is more opportunity for active small-cap managers to add value, since markets are less efficient and small companies have the potential to grow faster

-- Small companies are easier to understand, and the investment universe is very broad

-- Overall valuations look reasonable and are lower in Europe and Asia than the U.S.

True, small-caps stocks tend to outperform over longer time frames, and it's well-documented that small-cap value stocks in particular have been the best-performing asset class when tracked over many, many decades.

If the small-cap cheerleaders are right, the asset class may deserve a heavier weighting in your portfolio, but chasing individual names or piling into expensive, actively managed funds is almost certainly a bad idea. As always, a properly balanced portfolio still offers the best odds of achieving your long-term financial goals.

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    Dan Burrows, a veteran of Aol's DailyFinance, SmartMoney and MarketWatch from Dow Jones, covers the markets and economy with an eye toward investing for the long haul.

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